Last year, I brought Chinese off-road vehicle and electric vehicle
(EV) manufacturer Kandi Technologies (NASD:KNDI) to readers’
attention. I like Kandi because the company was already
profitable and trades for a tiny fraction of what a US-based EV
maker would.

The Kandi Coco is sold in the
US. Kandi's main focus in now on its native
Chinese market. Photo by Tom Harrison.

The Strategy

I also like Kandi’s electric vehicle strategy, which focuses on
inexpensive commuter vehicles combined with battery-swapping.
While this sounds a lot like the the strategy of recently
bankrupt Better Place, Kandi’s strategy avoids one of
the biggest problems with Better Place’s strategy: Kandi does not
have to bear the expense of extra sets of batteries or swapping
infrastructure. The batteries are owned by
the local utility, which can use them when they are not
in cars to provide stabilization and ancilliary services to the
grid. Kandi just (profitably) manufactures the cars and
licenses the battery swapping IP.

With the Chinese government in Beijing pushing hard for
more “New Energy Vehicles” as the Chinese call EVs in
order to cope with its horrific problem of urban
pollution, even China’s largest privately owned automaker, Geely
(HKEx: 175, OTC:GELYF) got religion, and has signed a 50-50 joint
venture to produce EVs with Kandi.

The Valuation

With Kandi already profitable based on its legacy ATV business, I
and other Kandi shareholders have long been frustrated that Kandi
does not trade at a much higher multiple of
earnings and revenue. Kandi has a trailing P/E
ratio of 20, and trades at less than 2 time trailing revenue.
Meanwhile EV high-flyer Tesla (NASD:TSLA) is trading at 13.5
time revenue, and 100 times next year’s expected earnings (Tesla
lost money last year, and is expected to only break even in 2013.)

The China Price

There are several factors contributing to
Kandi’s low valuation:

Kandi got its Nasdaq listing through a reverse merger, a
strategy which was followed by a number of other Chinese companies, many of which were
later found to have fiddled their books, absconded with
shareholder funds, or otherwise been frauds.

As a result of its small market capitalization and the general
wariness of Chinese stocks, no analysts follow Kandi.

A number of negative articles, many of which were written by
investors who were short the stock, have highlighted
irregularities in Kandi’s listing process and past reporting.

Although the negative articles about Kandi have been
disturbing, none of them have turned up anything wrong with
Kandi’s financial accounting. I’ve generally taken
this as a good sign. When the same group of people who made
good profits by shorting Chinese stocks and then exposing their
accounting frauds have been unable to turn up anything so serious
about Kandi, I have to wonder if there is anything to find.

With this in mind, I set out last month to parse through the
novel-length and rather dense Kandi-bashing articles to
demonstrate that there was nothing there for investors to worry
about. I failed, and instead found myself doubting the
judgement and/or honesty of Kandi’s management. I’d like to
emphasize that there is no proof of wrongdoing, but investors who
wish to hold on to their money don’t have the luxury of waiting
until their suspicions are confirmed beyond a reasonable doubt.

Sharesleuth

The most in-depth articles looking into irregularities
surrounding Kandi were written by Chris
Cary of Sharesleuth.
Carey is a former reporter for the St. Louis Post-Dispatch. Sharesleuth is
funded by Mark Cuban,
who often trades on the information Carey digs up before he
publishes his articles. Some people find this business
model distasteful but as Carey puts it, “If
Sharesleuth.com exposes fraudulent companies and Mark Cuban uses
profits from trades to finance more investigative reporting, then
I’m OK with that.” I’m also OK with it. I don’t see
the difference between Sharesleuth and any mutual fund manager who
goes on CNN to talk about his portfolio. Or between
Sharesleuth and a blogger
writing about stocks he owns on Forbes or Seeking Alpha,
for that matter.

The controversy
about Sharesleuth’s business model mostly seems to arise
because most of Cuban’s trades are on the short side. But in
the case of Kandi, Cuban was never short. I asked Carey
about this in an interview, and he responded that Kandi is a very
difficult stock to short. For a billionaire like
Cuban, the money he could make shorting a tiny stock like Kandi is
hardly enough to move the needle. Carey uncovered the
information in his articles in the course of investigations into
the people who brought it public, along with
ten other Chinese reverse merger companies,
including New Oriental Energy (OTC:NOEC), Telestone
Technologies Corp. (Nasdaq: TSTC); and Orsus Xelent Technologies
Inc. (OTC: ORSX). Many of these have since been delisted,
and Kandi is virtually alone among them for not trading
well below its initial offering price.

Clearly, Kandi should not be indited based on guilt by
association, and the scrutiny the company has been under
because of these associations should give us some confidence that
any past misdeeds are either very well buried or have already been
revealed. Nor do any of those misdeeds reach the level of
the outright accounting fraud found in many of the Kandi’s
reverse-merger brethren. Kandi has not been accused of
anything illegal.

From 2009 to 2011, Kandi significantly overstated
the number of EVs it sold. After Sharesleuth showed that
Kandi’s claimed sales of EVs were not supported by the number
imported or sold by Kandi’s dealers, the company quietly revised
its financial statements, revealing that many of its
claimed EV sales were actually sales of gas powered vehicles.

The Defense

Kandi’s defenders dismiss the first point as old news, saying
that what should really matter to investors is Kandi’s current
prospects. To the second point, they say that Kandi has
admitted its mistake, and the miscategorization of sales of gas
powered cars as EVs made no difference to Kandi’s revenue or
earnings in any of the affected years.

They also emphasize that Kandi is not accused of any criminal act
or fraud, and attempt to undermine the credibility of
Kandi’s detractors by calling the negative articles paid
hit pieces. Of course, Kandi’s defenders are long the
stock (as am I), which is at least as much of a bias as being
short.

My Take

I’m certainly happy that Kandi has not been accused of fraud, and
I do prefer to focus on Kandi’s future than on events
which occurred before I was ever a shareholder. On
the other hand, when we’re trying to predict how management will
behave in the future, our best evidence is how they have behaved
in the past.

In the case of unknown individuals profiting from the reverse
merger, this was at best bad judgment on the part of Mr. Hu,
Kandi’s President, CEO, and largest shareholder. The reverse
merger process seems to have needlessly diluted existing
shareholders, and also shows Mr. Hu working with a number of
unsavory characters, perhaps unwittingly. At worst, Mr. Hu
and his associates may have directly benefited from the
transactions in ways which were not disclosed.

Either way, the incident undermines my faith that Mr. Hu will do
everything in his power to protect the equity of the company’s
current small shareholders.

In terms of the misreported EV sales, the best case scenario is
that it was simply a translation mistake. I find this
scenario unlikely, because the
exaggeration occurred repeatedly over a couple years.
Nor does the fact that the mis-categorization of EV sales
did not affect reported sales or revenues mean that the number of
Kandi’s EV sales was not material to investors’ investment
decisions. The Kandi “story” depended on the growth of its
EV business even then: Here’s an article from 2010 making the link
explicit: Kandi
Tech Reports Strong Results, But Future Depends on Electric Car
Growth.

Other Evidence

After couple of my picks recently revealed that they would
have to restate their financial accounts because of misreported
revenue, I began using the Beneish
M-Score as an early warning system for earnings
manipulation. I calculated Kandi’s M-Score based on annual
accounts from 2010 to 2012, and on quarterly accounts for the last
three quarters. The M-Score combines factors which might
give a company an incentive to manipulate with factors which pick
up the distortions caused by common forms of earnings
manipulation. Details about how to calculate
M-Score and a spreadsheet can be found here. For nearly all
the periods I tested, M-Score indicates that Kandi has a moderate
chance of having performed some earnings manipulation.
Exactly what this probability is is hard to say,
but the M-Scores are a long way from giving an “all clear.”.
The 2010 annual report looks most likely to have been
manipulated, mainly because of a high level of receivables growth
relative to sales growth. Note that this period
coincides with the inflated EV sales numbers.

Companies can have high M-Scores without having manipulated
earnings, but a high M-Score says “proceed with caution.”
Maxwell Technologies (NASD:MXWL) had an M-Score in the third
quarter of 2012 that was similar to Kandi’s annual 2010 M-Score,
and the next quarter they announced that they had been
misreporting revenue since 2011. (I suspect
Maxwell’s mis-reporting may be greater in extent than has
yet been revealed.) M-Score will not flag all earnings
manipulation, but it may flag some honest companies as well.

Reading through Kandi’s filings, I noticed that Kandi’s largest
shareholder at the time of its listing was ExcelVantage
Group, a fund controlled by a Chinese retiree Tim Ho Man. In
2010, Mr. Tim transferred control of ExcelVantage
to Kandi’s CEO, Mr. Hu, “pursuant to a Transfer of Equity
Agreement” between them. Kandi’s listing documents made no
mention of any connection between Mr. Hu and Mr. Tim. While
it is possible that Mr. Hu bought ExcelVantage from Mr. Tim in an
arms-length transaction, it seems more likely to me that the two
men had an undisclosed agreement between them which gave Mr. Hu
effective control of ExcelVantage all along.

Once again, there is nothing illegal about this, but it
had the effect of obscuring the fact that Mr. Hu
retained a controlling stake of Kandi at the time it went public.
That’s something I would have wanted to know had I been
considering investing at the time.

Conclusion

There are a number of instances and red flags about Kandi’s
management that lead me to want to proceed with caution. At
the very least, the company has not been forthcoming with relevant
information that investors would have been interested in. A
company looking to build a reputation for good shareholder
relations would have disclosed this information. At worst,
the company may have intentionally misled investors regarding its
EV sales at a time when its accounts also showed signs of possible
distortion. If that’s the case, it would be reasonable to
assume that they will do something similar in the future.

On the other hand, the evidence of Kandi’s current progress at
building acceptance for its EVs is based not only on the company’s
statements, but a large number of articles in the Chinese press,
and agreements with
Geely and a number of Chinese cities and provinces. My
feeling from this is that Kandi will continue to rack up good
press and increasing EV sales for the rest of the year. The
fact that Kandi also recently filed an S-3
to allow it to sell additional securities also leads me to believe
that, if the company is likely to exaggerate its results, it will
do so in the coming months in order to boost the share price.

If you would like to read the full bull case for the stock, the
best place to start is to read these threerecentarticles
by Art Porcari.

After weighing the evidence, I no longer consider Kandi a long-term
hold. That said, my concerns about management are long-term in
nature, and I think Kandi’s short term trend will be up. This
article itself may cause a downward blip, but Kandi’s shareholders
are so used to negative articles about the stock that I doubt this
one will have any long term effect, and I expect Kandi’s upward
momentum will soon resume. I intend to maintain my reduced
holding to take advantage of that trend.

Update 6/10/13: The upward climb I predicted above started
much sooner than I thought, when a relatively minor news story about
a car developed for the Kandi-Geely JV
received approval from the Chinese government, and Kandi
finally caught some of the Tesla (NASD:TSLA) fever.
When I wrote this article 10 days ago, Kandi was trading around
$3.80, today it's trading at $6.50. I'm now mostly out of the
stock, having sold covered calls at $5, but I'm not ready to call a
top. As Tesla showed, once an EV stock catches investors'
imaginations, it can completely defy gravity and fundamentals.
Bottom Line: If you still own Kandi, enjoy the ride, but this
hot EV stock should be a rental, not a purchase or even a long term
lease.

Disclosure: Long KNDI stock, short KNDI covered calls, MXWL.

DISCLAIMER: Past performance is
not a guarantee or a reliable indicator of future results.
This article contains the current opinions of the author and
such opinions are subject to change without notice. This
article has been distributed for informational purposes only.
Forecasts, estimates, and certain information contained herein
should not be considered as investment advice or a
recommendation of any particular security, strategy or
investment product. Information contained herein has been
obtained from sources believed to be reliable, but not
guaranteed.